by Calculated Risk on 11/09/2005 09:47:00 PM

Here is the text of John Dugan's recent remarks at the OCC Credit Risk Conference. It is an easy read and well worth the few minutes. Dugan makes several key points:

1) This is the top of the credit cycle and standards are slipping.
2) Risk is overly concentrated in commercial real estate and residential mortgages.
3) Certain loans are especially risky.
4) The goal for the new interagency guidance is the end of 2005.

This is the "top of the credit cycle":

"... it’s at the top of the credit cycle where stresses and weaknesses typically appear, so what we are seeing today should not surprise anyone. With liquidity pouring into the market, we would expect to see increased competition for loan customers – and we are. With competition intensifying, we would expect to see underwriting standards easing – and we are. And we would expect to find emerging concentrations in some loan categories, such as commercial and residential real estate. We are most definitely seeing that."

And there is concern about mortgage risk:

"Today’s non-traditional mortgage products – interest-only, payment option ARMs, no doc and low-doc, and piggyback mortgages, to name the most prominent examples – are a different species of product, with novel and potentially risky features.
...
This dominance is increasingly reflected in the numbers. By some estimates, interest-only products constituted approximately 50 percent of all mortgage originations last year. In the first half of 2005, IOs started to decline in favor of payment-option ARMs, which, according to one source, comprised half of new mortgage originations. And roughly every other mortgage these days is also a “piggyback” or reduced documentation mortgage, which points to another development that concerns us: the trend toward "layering" of multiple risks. There is no doubt that when several risky features are combined in a single loan, the total risk is greater than the sum of the parts.

We can readily understand why these new products have become fixtures in the marketplace in such a short time. One reason is that they have helped sustain loan volume that would otherwise almost certainly be falling, because rising interest rates have brought an end to the refinance boom. More important, lenders have scrambled to find ways to make expensive houses more affordable – although there’s now a concern that the very availability of this new type of financing has done its share to help drive up house prices, which in turn stimulates demand for even more non-traditional financing."

And more on Option ARMs:

"And then there are payment-option ARMs, which take us to another level of risk. ... borrowers can easily treat payment-option ARMs in the same manner as a traditional mortgage, simply by selecting the fully amortizing option rather than the minimum payment option each month.

In practice, however, few borrowers treat them that way. Recent studies show that a significant number of borrowers are frequently choosing to pay the minimum amount possible, a payment amount that typically falls short of the interest accruing on the loan. Even more disturbing, this choice does not seem limited to high quality, affluent borrowers who may be using the product as a payment flexibility tool. The research indicates that borrowers at both ends of the FICO spectrum make this choice, with riskier borrowers resorting to it most frequently. Because such minimum payments fall considerably short of the total interest accruing each month, the unpaid interest is added to the loan principal, and negative amortization occurs. Thus, it should come as no surprise that, of the least creditworthy holders of payment-option ARMs, nearly 50 percent have current balances above their original loan amount."

And on the new interagency mortgage guidance project:

"This guidance will focus on underwriting standards, appropriate disclosure, and portfolio management concerns. Our current goal is to ready the guidance for release by year’s end, although serious interagency discussions about the initial draft have only just begun."

Well worth reading.

by Calculated Risk on 11/09/2005 08:51:00 PM

The Center for Economic and Policy Research released a new report today: "Will a Bursting Bubble Trouble Bernanke? The Evidence for a Housing Bubble". Dean Baker and David Rosnick conclude:

This paper has briefly examined three trends that strongly support the view that the recent run-up in house prices is driven by a speculative bubble, rather than fundamentals. First, it notes the unusual gap between the run-up in home sale prices and rents at both the national level and in many of the most inflated metropolitan markets. .... When such gaps have developed in the past, they usually have been followed by sharp declines in house sale prices.

The second factor suggesting that the current run-up reflects a bubble is the extraordinary pace of home construction in recent years. ... This pace of construction substantially exceeds that rate of new household formation. It is also worth noting that virtually no economists projected a sharp price in home construction in the mid-nineties, so most of the economists who expect the current pace of housing construction to persist, badly erred in their projections for housing construction in the past.

Finally, the wealth effect resulting from the recent run-up in house prices has led to a sharp decline in the savings rate. In recent months, the savings rate has turned negative. If construction continues at its recent pace and real house prices stay at current levels, then the savings rate will become even more sharply negative over the next decade.
...
It is not plausible that an economy will sustain a negative savings rate for any substantial period of time. This would imply that households’ non-housing wealth is continually declining. The more likely scenario is that housing prices will fall back in line with their historic values.
...
The costs of a collapse of the housing bubble will be even greater than the costs of the collapse of the stock bubble, because housing wealth is much more evenly held. The failure of the economics profession to adequately warn of the stock bubble was an act of extraordinary negligence. Missing the housing bubble is an even bigger mistake.

by Calculated Risk on 11/09/2005 06:14:00 PM

The Census Bureau will report the Trade Balance tomorrow morning. The concensus forecast is for a record trade deficit of $61.3B for September.

The impact of the hurricanes is a little uncertain. The Census Bureau has released preliminary trade information for the Gulf Region showing that exports were off about $1 Billion for the Port of New Orleans in September. However, imports were also off (about $0.5 Billion) and other Gulf ports picked up some of the export and import slack. My guess is exports will be impacted slightly - maybe $0.5 Billion.

Crude oil imports were off, but the volume of more expensive refined products increased. My prediction for the petroleum trade deficit is $21.1 Billion SA; a slight increase from the August record of $20.6 Billion.

The West Coast ports of Los Angeles and Long Beach reported record inbound traffic for September. Export traffic was down. Seasonally adjusted, imports from China were probably around the August level.

My prediction: A record trade deficit of $60.5 Billion.

by Calculated Risk on 11/09/2005 04:38:00 PM

DiMartino follows the money:

...it's a good thing the people running the homebuilding companies got out when they did.

So far this year, insiders at Toll have sold $588 million worth of the company's stock – representing nearly 10 percent of the current market capitalization. Robert Toll, chief executive, has liquidated north of $110 million.

As a group, Thomson Research senior quantitative analyst Mark LoPresti said, industry insiders have sold $976 million in 2005.
...
In the last six months, homebuilders have sold, on average, $347 for every dollar they've spent purchasing their own stock. Compare that to all industries, where insiders have sold $31 in stock for every dollar they bought.

Mr. LoPresti said July was the key month for homebuilder shareholders to watch what insiders were doing with their own shares.

"In July alone, homebuilding insiders liquidated 4.8 million shares of stock, the largest number in history, raising $333 million," Mr. LoPresti said.

The last time homebuilder insiders were this aggressive was May 1991, when they sold off 3.1 million shares in one month. This was followed by a 27 percent decline in homebuilder stocks over the next four months.

by Calculated Risk on 11/08/2005 10:32:00 PM

Drs. Tim Duy and William Polley discuss Bernanke and the FED: Changing Times at the Fed This is an excellent discussion of a number of topics: Fed credibility, inflation targeting, inflation measures, "global savings glut" and more.

NOTE: Here is Dr. Polley's blog and Dr. Duy writes the regular Fed Watch feature on Dr. Thoma's Economist's View.

From the WSJ Econoblog: Both Drs. Duy and Polley believe Bernanke's "helicopter drop" comments were misunderstood by the general public. See this 2002 Bernanke speech: Deflation: Making Sure "It" Doesn't Happen Here

Dr. Polley comments:

In one line of his speech, Mr. Bernanke uses the illustration of the "helicopter drop" of money -- an illustration first used by Milton Friedman -- to describe a money-financed tax cut that should have the desired effect of ending the deflation. It was, of course, widely acknowledged that the risk of deflation was slight and that this was a "worst case" scenario.

Fortunately, deflation did not materialize, but many people worried that Mr. Bernanke's use of this illustration weakened his credentials as an inflation fighter. I don't share that concern, but beliefs and expectations are very important in central banking. Any doubt about the Fed's credibility means that they will have to raise the real rate further to re-establish those credentials.

Dr. Duy concurs:

I have worried that continued allegations of Mr. Bernanke as an inflationist -- allegations that I believe are false -- are increasing the possibility of policy error in the months ahead. That said, I believe that my worries will prove to be unfounded at the end of the day.

An excellent discussion.